I am Co-Director (formerly Head of Economic Research) at independent think-tank Open Europe, which focuses on reforming and improving the EU. Over the past few years I have led Open Europe’s research into the eurozone crisis and into the regulatory response to the financial crisis in Europe. My research has focused on the ECB and the monetary policy response to the crisis as well as on the series of eurozone bailouts in the periphery countries. On top of my posts here, I regularly contribute to print and broadcast media, with my talking head occasionally popping up on CNBC, Sky and others. Prior to joining Open Europe, I gained experience in global credit risk management at a development bank. I hold two Masters Degrees in Economics and Public Policy from the University of Chicago and a BA in Economics and Politics from the University of Manchester. When not wrapped up in the eurozone and EU, I like to research global macroeconomics, demographics and the changing structure of the global economy.

ECB Stands Firm Despite Deflation Threat -- Here's Why

In the past month we’ve heard from the IMFIMF, OECD and countless commentators warning of the risks of not taking action to fight the threat of low inflation and potentially deflation in the eurozone. The ECB has stood firm.

Much of this analysis makes it seem as if there is a pretty clear cut case in favour of further easing. But if that is true then why is the ECB sitting on its hands? After all, ECB President Mario Draghi has shown himself willing to take action when needed.

My feeling is that there are two broad reasons. The first being that the flow of data is mostly positive, and the second, more important factor, being that none of its tools are economically, politically or legally suited to tackling the low inflation environment in the eurozone.

Let us start with the data. It’s important to realise that the ECB predominantly acts on the flow of data not stocks. As such, it analyses data from meeting to meeting and often only changes course if there is a sizeable shift from the previous or recent meetings. It’s more a stream of consciousness than a fresh assessment every month of the wider macro situation.

Over the past month (and since the start of the year) the data has been pretty solid. Far from spectacular, this is the eurozone after all, but certainly not the downward shift the ECB would require to prompt action. The Markit Purchasing Managers Index (PMI), an indicator of private sector activity shown in the graph above, has continued to increase for most eurozone countries (although with France being worryingly left behind). Eurozone GDP growth came in at the expected 0.3% for the final quarter of last year, while consumer price inflation came in at 0.8% – 1% if you strip out the short term impact of energy and food – above expectations. On top of this the recent volatility in short term money market rates has eased, subduing fears of tightening money market conditions.

All that said, stepping back and looking at the big picture, it’s clear that there is a downward trend in inflation and it’s obvious that growth and employment remain at very low levels in the eurozone. However, when Draghi looks at his ‘toolkit’ laid out on the table, I can’t help but feel that he might not see the right tool for tackling this challenge.

In fact, I believe he hinted at as much in his press conference today. When pushed on why the ECB refused to introduce a new stimulus Draghi retorted – “one must ask, what kind of stimulus?” He highlighted that many of the problems facing the eurozone are structural and cannot be fixed by further easing, pointing to the upcoming bank stress tests and recapitalisation as an example of a more suitable policy.

Peeking into Draghi’s toolkit provides a bit more colour to this picture. I think we can fairly assume that given the broken transmission mechanism and already almost zero interest rates, a standard rate cut is essentially pointless beyond a token gesture. The same goes for the unlimited liquidity which has been present since 2008 and which forward guidance has basically forecast will be in place for some time to come. This leaves four serious options at the ECB’s disposal: a funding for lending type liquidity scheme, a negative deposit rate, purchases of private sector assets and quantitative easing (buying government debt).

Let’s take a bit of a deeper look at these specific tools.

Funding for lending This would see liquidity provision targeted at promoting lending to the real economy, given that previous long term lending has failed to boost loans to the private sector. This would be a relatively easy option to take, however, its effectiveness would likely be limited. It is difficult to target lending when you are already providing unlimited liquidity. Sure, the ECB could offer longer maturities and slightly lower rates but banks have already repaid much of the previous long term liquidity and show little appetite to take on more, especially if it means ramping up more risky lending.

Negative deposit rate The logic here is that banks will be charged for holding excess reserves at the ECB and therefore will be forced to lend them out. I’ve given a detailed run down of this over on the Open Europe blog, but I have a strong feeling that this could end up being counterproductive. Banks could actually cut excess liquidity in response and shrink their balance sheets, thereby reducing lending. They could also pass costs onto consumers and drive rates on safe assets even lower as they search for safe liquid assets for their short term cash holdings. Clearly, either or both effect would fail to boost growth and inflation.

Private sector asset purchases This would see the ECB purchase certain assets, notably Draghi has suggested the ECB could buy up packages of loans to businesses, i.e. asset backed securities (ABS). Unlike in the US and UK the ABS market in Europe is significantly underdeveloped and currently there are only around €131bn in ABS linked to loans to businesses outstanding. This avenue then wouldn’t provide much scope for a large liquidity injection and would take some time for the market to develop. Draghi himself warned on this today and called for legislative changes to boost the size of the market. Again a longer term option but not well suited to the current challenges.

Quantitative easing Again, I’ve given a more detailed run down on the Open Europe blog, but the key point here is that it would be nigh on impossible to target these purchases where they are needed. The biggest deflationary forces are still coming from the peripheral economies. However, QE purchases would need to be split up according to the shares which each country has in the ECB. This means that close to 30% would go to Germany and 20% to France. So the programme would be have to be huge to have any impact in the smaller states, which risks the side-effects also becoming significant. As the programmes in the US and UK have shown the overall impact on growth and inflation is far from clear, while unwinding such purchases can be incredibly challenging. Moreover, the political obstacles in Europe are massive. Germany would seriously question its position if such a programme were unleashed, while it would certainly face legal challenges such as those seen against the current ECB bond buying programme the OMT.

All in all then, the tools at the ECB’s disposal are far from suited to helping push up inflation in the struggling countries and boosting lending to the real economy to help economic growth. This is not to say the ECB would never use them, but that are better suited to a deeper more acute crisis (such as a break-up threat) than the chronic long term malaise which the eurozone currently finds itself in.

The ball is now in the governments’ court and the ECB seems keen to keep it there. Getting the economy back on track will require serious progress on overhauling the banking sector and on creating a proper banking union, something which the eurozone is well behind schedule on.

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